HKUST Business Review

n December of 2003, one of the largest corporate scandals in European history broke: The Italian dairy and food corporation Parmalat admitted that it had concealed billions of euros in debt and falsified financial statements in an effort to hide its serious financial troubles. Financial analysts were shocked. In Q2 of 2003, the vast majority of analysts were still issuing “buy” or “hold” ratings for Parmalat. And yet, as early as November of 2002, two credit rating agencies (CRAs) were telling a different story: Both Standard & Poor’s (S&P) and Moody’s Investors Service had already begun downgrading Parmalat’s credit rating due to concerns about its financial health and transparency. Why were these CRAs able to see what so many analysts had missed? Investors often rely on analyst reports to avoid investing in companies that are engaged in fraud, but Parmalat’s downfall demonstrates that reports from analysts with limited access to private information may not reflect a company’s true financial condition as accurately (or as far in advance) as CRAs that can incorporate more extensive private information into their ratings. Interestingly, this flies in the face of many investors’ assumptions. After all, the reason CRAs like S&P have better access to private information is that they are paid by the companies they rate, suggesting that conflicts of interest might keep them from revealing their customers’ fraud. In contrast, other rating agencies, such as the Egan-Jones Rating Company (EJR), are paid by investors, eliminating this potential conflict of interest. However, Parmalat’s story and our recent research suggest that despite heightened risk of conflicts of interest, S&P’s access to private information means that their ratings signal fraud earlier and more reliably than those of analysts who must rely largely on public data. WHEN CREDIT RATINGS PREDICT FRAUD FRAUD PREDICTION Despite heightened risk of conflicts of interest, agencies that are paid by the companies they rate actually predict fraud earlier and more accurately than other analysts. Allen HUANG, WANG Shiheng Authored by Insight 40 HKUST Business Review